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Today SR market equilibrium Changes in equilibrium LR equilibrium Print out slides #26 & 28 full-sized to have more room to work. Short-Run Market Equilibrium The price must clear the market (QD = QS). Every firm must be profit-maximizing, given its costs and the market price. Firms may be making profits or losses. Graph of SR Market Equilibrium P Typical Firm P Industry or Market SRS MC ATC P* P* AVC D q Does this firm produce in the short run? If so, how much? Q* Q Graph of SR Market Equilibrium P Typical Firm P Industry or Market SRS MC ATC P* =MR P* AVC D q* q Q* Does this firm make profits in the short run? If so, how much? Q Graph of SR Market Equilibrium P Typical Firm P Industry or Market SRS MC ATC P* =MR P* AVC D q* q Q* P - ATC = profit per unit. Does the rectangle go to the bottom of ATC? Q Decrease in Demand P Typical Firm P Industry or Market SRS MC ATC P* AVC P’=MR q’ q* q Q’ D’ D Q* Q ATC - P = loss per unit. Does the rectangle go to the bottom of ATC? Results of Decrease in Demand Market price falls. Firm responds by cutting its output. This firm makes losses but still produces in the short run. (Why?) Market quantity falls. Further Decrease in Demand P Typical Firm P Industry or Market SRS MC ATC P* AVC P’’= MR D’ D Q’’ Q’ Q* What does this firm do in the short run? Why? Q D’’ q’’ q’ q* q Firm Supply in the Long Run If price is less than ATC, a firm makes losses in the short run. Such a firm will shut down in the long run. Therefore, the firm’s long-run supply curve is its marginal cost curve above ATC. Graphing the Firm’s Supply Curve P P3 LRS SRS MC ATC AVC P2 P1 P0 q Long-Run Equilibrium The key to understanding the LR is firm entry and exit. The Key Profits are a signal for resources to flow into the industry: new firms enter. Losses are a signal for resources to leave the industry: firms exit. Conditions for Long Run Equilibrium The market price clears the market. Firms must max. profits, given their SR constraints. Firms do not make profits or losses. Firms must be at their lowest SRAC, given their level of production. – The assumption “room for many firms” implies firms produce at the lowest level of their LRAC curve. Adjustment to LR Equilibrium P Typical Firm P Industry or Market SRS MC ATC P* P* D q Q* What do you expect will happen in the long run? Q Adjustment to LR Equilibrium P Typical Firm P MC Industry or Market SRS SRS’ ATC P* P* P’ D q Q Q* Profits attract entry. Price falls. Firm’s output falls, market output rises (why?). What happens to the firm’s profits? Is this LR equilibrium? Adjustment to LR Equilibrium P Typical Firm P MC Industry or Market SRS SRS’ ATC P* P* SRS’’ P” D q” Q Q* Q” Entry continues until the firm no longer earns profits. Is this LR equilibrium? q LR Equilibrium P Typical Firm P Industry or Market MC ATC LRATC SRS’’ P” D q” q Q Q* Q” In long run equilibrium, firms in a perfectly competitive market will operate at the lowest point on their LRAC curves. Adjustment to LR equilibrium: Case of Initial Profits Profits attract new firms into the market, increasing market supply. Market price falls. All firms must cut back output and see lower profits. Market quantity rises, though, due to larger number of firms. Process continues until profits fall to zero. Initial Losses P Typical Firm P Industry or Market SRS MC ATC P* AVC P=MR D q* q Why is this not LR equilibrium? What will happen in the LR? Q* Q Firm Exit If a firm is making losses, then it will get out of business as soon as possible – expiration of lease, sale of property, etc. Exception: if it expects market conditions to improve soon enough, it may decide to wait it out. – May wait for others to exit first, or demand to increase. Note this could be quite costly. We usually ignore this possibility. Initial Losses P Typical Firm P MC Industry or Market SRS’ SRS ATC P* AVC P’=MR’ P=MR D q* q Q* Firms exit. Market price rises. Remaining firms produce more. Losses shrink. Market output falls. Is this a LR equilibrium? Q Initial Losses P Typical Firm P MC Industry or Market SRS’ SRS SRS” ATC P* AVC P”=MR” P=MR D q*q” q Q” Q* Firms exit until none make losses. Is this a LR equilibrium? Q Coming Up: LR Industry Supply—3 Cases Market Efficiency Group Work LR supply SR industry equilibrium The Firm’s LR Supply Curve In the long run, if the market price is $3, what quantity will the firm produce? _____ In the long run, if the market price is $5.25, what quantity will the firm produce? _____ In the long run, if the market price is $7.50, what quantity will the firm produce? _____ Trace out the firm's long-run supply curve. How does this compare to the SR supply curve from the last lecture’s problem? Firm’s LR Supply Curve $/q 12 MC 10 8 ATC AVC 6 4 2 0 0 2 4 6 8 10 12 14 16 18 20 22 24 Quantity Short Run Market Equilibrium Indicate all of the following answers on the graph for the short run. – – – – – – – – – Equilibrium market price (P*) Equilibrium market quantity(Q*) Firm's output (q*) Price firm charges (p*) Demand for firm's output (d) Firm's marginal revenue (MR) Firm's average revenue (AR) Firm's average profit/loss per unit Firm's total profit/loss. SR Industry Equilibrium $/q 12 MC SRS Typical Firm 10 8 ATC 6 D 4 Industry 2 0 0 2 4 6 8 10 12 Quantity 0 200 400 600 800 1000 Quantity